Crack in the market always comes with cacophony. Investors should be wise enough not to wait for cacophony to clear and instead focus on picking undervalued stocks with high margin-of-safety without yielding to the temptation to time the bottom. As someone wise said, if you wait for robins, spring will be over.
Instead of timing, the focus should be on Margin-of-Safety (MOS). Let us turn to the anecdote of coin flipping to understand more on the concept of MOS. As we know, flipping the coin is a risky bet. Is there a way to improve odds in that? What if, heads you win and tails you do not lose? Though odds of winning do not improve, odds of not losing improve to 100%. This is exactly what Margin Of Safety does in investing. Strangely, in investing, when you are focused on downside, upside takes care of itself. Value investing is all about downside protection and MOS is the magnificent tool to mitigate the downside risk. It is the magical concept that magnifies the portfolio returns by denting the drags from losers and by earning exceptional rewards from winners. To quote Ben Graham, “Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, Margin of Safety”
How does one get MOS in stock picking? If MOS is defined as the discount from the intrinsic value of the underlying business, primarily, it comes from the mis-pricing in the markets. Mispricing can happen on two counts. One from the broader market trend and the other from stock specific scenarios(when underlying business comes across short-term bumps). In general, mispricing is on the upside when the mercury is up and it is on the downside when there is meltdown. It applies both to stock-specific swings and to overall market moves.
The challenge is not so much about getting MOS opportunities. Vicious corrections even in a virtuous bull market are not very unusual. Similarly, stock specific slumps are not scarce in a secular uptrend. The harder part is more about having the nerve to invest when such MOS opportunities arise, as in most cases, the accompanying high decibel narrative numbs the investors into inaction. Take for example the ongoing correction. Last week, small and midcaps were mauled mercilessly (continuing as we write this). For most of the stock prices, the clock was back by one year. Yet, the same people who were waiting on the fence for a sharp correction, turned frozen because of the changed narrative. As they say, money is made not in following narrative, but in following valuations. Narrative will take care of itself as time goes. MOS grows in manic pessimism. Time to start nibbling is when narrative turns negative. If you wait for cloud to clear, MOS too will mysteriously disappear.
“Current market weakness is nothing but market’s way of adjusting to the weakening macro. Market never adjusts in an orderly fashion. To that extent, as market adjusts to the new macro challenges, expect lot more bumps and humps in the coming months”
But time to bet is when these bumps and humps bombard, not when it becomes seamlessly smooth. While macro may not be at its best, underlying recovery in micro (recovery in corporate earnings) may provide the required support in the medium to long-term.
Happy Value Investing!!